Fine-Tuning Monetary Policy in the Americas

Remarks delivered at the International Economic Forum of the Americas on April 13, 2015.

Dear Mr. Chairman,

Thank you for the opportunity to be part of this distinguished panel and to share my views on the impact of international economic developments on Latin American economies and policies. My perspective is that of an international economist and global money manager. I am not an expert on Latin America, but I have observed the region over the past four decades both in good times and bad, including the lost decade of the 1980s, the 1994-95 "tequila crisis," and the problems Argentina and Brazil confronted at the start of the last decade.

As the description to our session notes, Latin American economies proved highly resilient during the 2008 Global Financial Crisis. However, some observers are worried about storm clouds on the horizon stemming from falling oil and commodity prices, a strong U.S. dollar, and the prospect of Fed tightening later this year. Accordingly, the main issue I will address is: How concerned should investors and policymakers be about the external environment and its impact on the region?

An Unusually Complex Environment

In assessing the prospects for Latin American economies, one should first recognize how complex the global environment has become since the second half of 2014. Indeed, most forecasts that were made late last year are out–of-date in light of all that has transpired:

Oil prices have plummeted by 50%+, and other commodities have softened.

The U.S. dollar has appreciated by about 20% on a trade-weighted basis.

Interest rates in many European countries are negative now, as the ECB attempts to lessen the risk of deflation via quantitative easing.

At the same time, the Federal Reserve is preparing the market for an eventual tightening of monetary policy.

Normally, any one of these considerations would merit extensive analysis and debate. How, then, can anyone be confident knowing how they will play out in their entirety?

My answer is this is a difficult task, but one that must be addressed. My approach is to consider each of these issues separately, while also recognizing they are inter-connected.

To begin, the impact of lower oil prices on the region is varied, as they are a positive for countries that are net oil importers and a tax on countries that are net oil exporters. Within Latin America, the largest net exporters of oil are Venezuela, Mexico, Columbia, and Ecuador, which have been adversely impacted by the drop in oil prices. Brazil is also a large exporter of oil including ethanol, but it consumes more oil than it produces. Most other countries are net oil importers, and therefore benefit from lower oil prices.

At the same time, Latin America is a commodity-exporting region, and the deterioration in the terms of trade poses the most challenging external environment in more than a decade. Because most Latin American countries link their currencies to the dollar, they are also experiencing a dampening effect on economic growth and inflation as the dollar has strengthened. As I will note subsequently, however, the countries that are experiencing the greatest difficulties are ones with weak currencies, relatively high inflation, and large external deficits.

With respect to monetary policies abroad, the stance of the Federal Reserve is much more important to the region than that of the ECB, given the close ties to the United States and the dollar. Therefore, I will highlight the likely stance of U.S. monetary policy.

Diverse Economic Performance

Not surprisingly, economic performance in the region has been very diverse. The good news is that most Latin American countries have been able to maintain satisfactory growth and moderate inflation in difficult circumstances. Moreover, the majority of countries do not face large external financing requirements, which plagued the region from the 1970s through the 1990s.

At the same time, several prominent economies are experiencing difficulties due to domestic and external circumstances. The problems in Argentina – including the default on its debt and nationalization of assets – predate the recent changes in the global economy, and they are mainly domestic in origin. Investors are now waiting to see if the current stalemate over the NY Court ruling that it should pay holdout bondholders will be resolved after the presidential election this year.

Meanwhile, Venezuela's economy has deteriorated considerably in the wake of the plunge in oil prices, as its export revenues have plummeted, and its government finances have deteriorated. The country is forecast to experience a severe recession this year, in which real GDP could contract by as much as 5%. These developments and worries about the political situation, in turn, have spawned capital flight that has contributed to a tightening of credit availability. Consequently, there are growing concerns about the country's ability to service its external debt if the current situation persists.

The economy that is of greatest interest to international investors is the region's largest, namely Brazil, where there has been a rapid buildup in corporate debt since 2008. Because only 8% of Brazilian government debt is dollar-denominated, there is less of a sovereign debt concern. Rather, the main concern is Brazil could be on the cusp of recession, as exports have slowed and monetary policy and fiscal policies have been tightened to combat inflation and to rein in the budget and current deficits. While the policy changes are steps in the right direction, they also increase the risk that private borrowers may encounter debt service difficulties at some point. Adding to concerns is the corruption scandal and fallout involving Petrobras, which has undermined confidence in the country's leadership.

The bottom line is these three economies are operating in what I call the "crisis zone" – namely, their currencies are under pressure and domestic interest rates are very high despite economic weakness.

Fed Tightening: How Much of a Threat?

Given these circumstances, what is the risk that the Federal Reserve could further add to problems in the region by tightening U.S. monetary policy aggressively? This was a major concern for emerging economies two years ago, when U.S. bond yields surged as the Fed announced it was contemplating ending quantitative easing, although pressures have lessened over the past year.

My take is that the risk of the Fed tightening monetary policy aggressively is fairly low. The reason: The leadership of the Federal Reserve will not do anything that could derail the U.S. expansion. At the latest FOMC meeting in March, for example, the Committee dropped the term "patience" from its policy statement, while adding the caveat that it needed to be confident the economy was poised to achieve 2% inflation before it would act. This contributed to a rally in U.S. bonds and risk assets.

Subsequently, Chair Yellen has indicated that the Fed would proceed very cautiously in raising rates once it undertook its initial move: "… the actual path of policy will evolve as economic conditions evolve, and policy tightening could speed up, slow down, pause, or even reverse course depending on actual and expected developments in real activity and inflation."[1]

Accordingly, the U.S. bond market currently is pricing in only two 25 basis point hikes in the funds rate this year, and a fed funds rate of only 1.5% by year-end 2017. While these levels could prove to be too low, the Fed will need to be confident the U.S. economy is on solid footing before it quickens the pace of tightening. Consequently, I do not foresee Fed policy tightening as being a major risk to Latin America this year.

In my view, the principal challenge confronting most Latin American economies will be to navigate through soft commodity prices and a resurgent dollar, while the problems confronting Argentina, Venezuela, and Brazil are considerably greater for the reasons I cited.

Thank you very much.

[1] See "Normalizing Monetary Policy: Prospects and Perspectives," presented at the Federal Reserve Bank of San Francisco, March 27, 2015.

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